Keynes on Nominal Wage Flexibility

At the conclusion of Chapter 19 of the The General Theory, after showing how nominal wage flexibility is unlikely to be a reliable general solution to involuntary unemployment, Keynes noted how such nominal wage flexibility would also likely lead to further economic problems:

“It follows, therefore, that if labour were to respond to conditions of gradually diminishing employment by offering its services at a gradually diminishing money-wage, this would not, as a rule, have the effect of reducing real wages and might even have the effect of increasing them, through its adverse influence on the volume of output. The chief result of this policy would be to cause a great instability of prices, so violent perhaps as to make business calculations futile in an economic society functioning after the manner of that in which we live. To suppose that a flexible wage policy is a right and proper adjunct of a system which on the whole is one of laissez-faire, is the opposite of the truth. It is only in a highly authoritarian society, where sudden, substantial, all-round changes could be decreed that a flexible wage policy could function with success.” (Keynes 1964 [1936]: 269).

Was there ever a golden age of flexible wages in the modern economic history?

Empirical data on the US seems to show that nominal wage cuts appear common enough in the pre-1914 era (Hanes and James 2003: 1417–1418), but nevertheless other data shows that a strong degree of nominal wage rigidity already developed by the late 19th century, and industrial workers seem to have vehemently opposed money wage cuts even by the 1880s (Hanes 1993). It seems clear that significant social and institutional changes affecting how wages are set have occurred since the 19th century.

Much the same thing can be said about prices. Prices appear to be more flexible in the 19th century, but the reasons for this are probably that (1) mark-up/administered prices were less prevalent than in the modern world, and (2) as argued by John Hicks there may have been important institutional changes in Western economies from the late 19th to the early 20th centuries.

To expand on point (2), Hicks postulated that by the early 20th century the role of wholesale merchants and dealer-wholesalers had declined to a great extent: in the 19th century, such wholesale merchants had enabled a much higher degree of price flexibility, but their decline and the rise of large industrial enterprises (which tended to fix prices on the basis of costs) caused strong downward price rigidities to emerge. The increasing downwards inflexibility of nominal wages will have contributed to this.

So did the 19th century economy function in the way predicted by neoclassical theory? That is, did it have a strong and rapid tendency to full employment brought about by price and wage flexibility clearing markets?

Even with a much higher degree of price and wage flexibility than today, there are many reasons to think that it did not, since there were persistent and severe economic problems in both Europe and America in the 1870s and 1890s, a period of business pessimism and “profit deflation” in the long deflation of 1873 to 1896, recurrent financial crises, and strong evidence that debt deflation was a crippling difficulty for certain classes of people.

Moreover, involuntary unemployment was clearly a serious problem in the 1870s and 1890s, and for various reasons it may well be that the best estimates available today are actually serious underestimates of the 19th century unemployment rate.

All in all, the neoclassical view of how markets function seems highly dubious, even for the 19th century.

Further Reading
19th Century Economic History.

BIBLIOGRAPHY
Hanes, Christopher. 1993. “The Development of Nominal Wage Rigidity in the Late 19th Century,” The American Economic Review 83.4: 732–756.

Hanes, Christopher and John A. James. 2003. “Wage Adjustment under Low Inflation: Evidence from U.S. History,” The American Economic Review 93.4: 1414–1424.

Keynes, J. M. 1964 [1936]. The General Theory of Employment, Interest, and Money. Harvest/HBJ Book, New York and London.